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Macroeconomic effects of tax changes: Estimates from a new measure of fiscal shocks

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U.S. 1040 tax form (iStock)

Few issues in American politics prompt more partisan passions and conflicting points of view than tax policy. One would think that there would be a definitive historical record of successes and failures that could inform future policy, but since other macro economic trends are operating at the same time, it can be difficult for economists to isolate the impact of tax cuts and hikes independent of these confounding factors.

A 2010 study from the University of California, Berkeley, published in the American Economic Review, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” aims to establish a definitive record of tax cut impacts after World War II independent of significant simultaneous economic trends (or “exogenous” tax changes.)  The study uses historical documentation to establish the rationale for, and context around, tax policy shifts, and seeks to “use the information on motivation to separate the legislated tax changes into those that are likely to be contaminated by other developments affecting output, and those that can legitimately be used to measure the macroeconomic effects of tax changes.”

The study’s findings include:

  • 54 study examples — slightly more tax cuts than tax hikes — fit the criteria for an exogenous tax policy shift, a “substantial fraction” of all postwar tax changes. Some changes were enacted to help reduce deficits, while others were intended to stimulate long-term growth.
  • The “implied effect of a tax increase of one percent of GDP” is “consistently negative,” that is, “tax increases appear to have a very large, sustained, and highly significant negative impact on output.” In the first three quarters that the tax change is in effect, “the effect is small and not significant. It is then steadily and rapidly down for the next two years before rebounding slightly in the final two quarters.”
  • As a general rule, “an exogenous tax increase of 1% of GDP lowers real GDP by almost 3%,” though when other factors are taken into consideration, the figure may be more in the range of 2.5%. This contraction happens in part because “investment falls sharply in response to exogenous tax increases.”
  • However, the study finds “evidence that tax increases to reduce an inherited budget deficit do not have the large output costs associated with other exogenous tax increases.”

The authors acknowledge that this area of study could be made even more precise: “There are strong reasons to expect the effects of a tax change on output to depend on such features of the change as how far in advance it is expected, its perceived permanence, its impact on marginal tax rates, and how it affects the tax treatment of investment … By systematically gathering information about characteristics of our exogenous tax changes, one could investigate whether the output consequences of tax changes depend not only on their size, but on their other features as well.”

Tags: Congress, economy, taxation, municipal, campaign issue

    Writer: | Last updated: September 14, 2011

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    Media analysis

    Read the issue-related New Yorker article "The Ringleader: How Grover Norquist Keeps the Conservative Movement Together."

    1. Using the study and article as starting points, discuss the problems of separating politics from objective policymaking when it comes to taxes in America. What are some of the difficulties reporters face in covering tax debates and evaluating the merits of proposals?

    Analysis assignments

    Read the full American Economic Review study "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks."

    1. Summarize the study in fewer than 40 words.
    2. Express the study's key term(s) in language a lay audience can understand.
    3. Evaluate the study's limitations. (For example: Do the results conflict with those of other reliable studies? Are there weaknesses in the study's data or research design?)

    Newswriting assignments

    1. Write a lead (or headline or nut graph) based on the study.
    2. Spend 60 minutes exploring the issue by accessing sources of information other than the study. Write a lead (or headline or nut graph) based on the study but informed by the new information. Does the new information significantly change what one would write based on the study alone?
    3. Interview two sources with a stake in or knowledge of the issue. Be prepared to provide them with a short summary of the study in order to get their response to it. Write a 400-word article about the study incorporating material from the interviews.
    4. Spend additional time exploring the issue and then write a 1,200-word background article, focusing on major aspects of the issue.